Some prominent institutional bond investors are shifting their focus away from traditional benchmark indices that weight countries’ debt issues by market capitalization, toward GDP-weighted indices.   PIMCO (Pacific Investment Management Company, LLC, the world’s largest fixed-income investment firm) and the Government Pension Fund of Norway (one of the world’s largest Sovereign Wealth Funds), have both recently made moves in this direction.  

There is a danger that some investors will lose sight of the purpose of a benchmark index.   The benchmark exists to represent the views of the median investor dollar.  For many investors, going with the benchmark is a good guideline - especially those who recognize themselves to be relatively unsophisticated and also those who think they are sophisticated but really aren’t.   This is the implication of the Efficient Markets Hypothesis (EMH), for example.  

On the one hand, EMH theorists are often too quick to discount the possibility of ways to beat the benchmark.   To take an example, it should not have been so hard to figure out during the 2003-07 credit-fed boom that countries with high foreign-exchange-denominated debt, particularly in Europe, were not paying a sufficiently high return to compensate for risk.  That mistake described Eastern European countries with low ratios of reserves to short-term debt as well as periphery euro members that lacked their own currency.  It probably resulted from easy money, reach for yield, and pervasive underestimation of risk.  Or, to take another example (admittedly, a tougher call), some of these countries’ deeply discounted bonds would have been good buys in early 2012, after heavy mark-downs.   

On the other hand, most investors would do better if they went with a more passive investment strategy - especially due to high management fees among actively managed funds, exacerbated by excessive turnover.   At a minimum, if one is pursuing an activist strategy such as investing more in low-debt countries, it is helpful to frame it explicitly as a departure from the view of the median investor in order to be clear in your mind as to the nature of the bet you are making.

I can think of four functions of a benchmark index.    First, investors who do not figure that they can systematically beat the median investor need to be able to hold passively a portfolio designed to track a benchmark index consisting median investor holdings.   (See Vanguard.)   The second function is to provide an objective standard by which investors can judge the performance of active portfolio-managers who claim to be able to beat the median investor, within a specific asset class like sovereign debt.  (See Morningstar.)   Third, the same weights that are used in the index can be used to compute an average interest rate or sovereign spread in the market, which can serve as an indicator as to where the median investor is currently, in the risk-on, risk-off spectrum. (See J.P.Morgan’s EMBI — Emerging Market Bond Index.)    

The fourth function of a benchmark index is to help active investors to devise a deliberate strategy to depart from the views of the median investor when they think that the latter is erring in a particular direction.  They may think that the median investor is under-estimating risk in general (spreads too low) or under-estimating the downside in countries with some particular characteristic.   Examples of such characteristics include insufficient currency flexibility, inadequate reserves, too much short-term debt, too much foreign-currency debt, too much bank debt, insufficient openness to FDI, insufficient cost competitiveness, excessive budget deficits, insufficient national saving, political risk, and so forth.

For each of these four functions of a benchmark, the correct way of weighting different countries is by market capitalization.  True, the keeper of the index will need to judge what countries and what bonds are in “the market,” i.e., are fully investable.   But this is true for any index.

The logic behind the movement away from traditional bond market indices is that by construction they give a lot of weight to countries with high debt, some of which may be over-indebted and at risk of default.  At first the logic seems unassailable.  But in theory, if the market is functioning well, it should already have factored in high debt levels:  such countries should pay higher interest rates to compensate for the risk, unless there is some special reason to think they can service their debts easily.

It is important to emphasize that many investors will want to depart from the benchmark in various directions, as indicated under the fourth motive for having a benchmark.  An investor’s belief that countries with high debt/GDP ratios are riskier than the median investor realizes would call for a strategy equivalent to moving from the market-cap benchmark in the direction of the GDP-weighted benchmark.  But one is more likely to think about the strategy clearly if it is explicitly phrased in terms of factoring in debt/GDP ratios, rather than phrased as following a new GDP-weighted index.  Furthermore the phrasing may help an investor realize that he or she might want to modify the strategy if, for example, the country in question can borrow readily in terms of its own currency (think of American exorbitant privilege or Japan’s high domestic holdings of own debt) or if, on the other hand, its debt has a particularly vulnerable maturity or currency structure (think of Hungary).

Investors are reacting to what has turned out to be default risk that was higher than they had expected, among some high-debt countries.  Taking greater note of high debt levels last decade would have warned investors away from countries like Greece and Hungary.   But there is always a danger of fighting the last war.   Middle-income countries have paid down much of their debts over the last decade, attaining debt/GDP ratios far below those of advanced economies.    As the chart shows, major emerging markets have relatively low debts [first bars, for each country] compared to GDP [second bar].  That is, their debt/GDP ratios [third bar] are now much lower than in advanced countries.  (Russia’s sovereign debt is now below 7 per cent of GDP.)  As a result, there is only a limited supply of their bonds left to hold.  If the global investor community switches from market-cap-weighted to GDP-weighted investing, the high demand and low supply of bonds from low debt/GDP countries may drive their interest rates to unnaturally low levels, setting off new credit-fed boom-bust cycles in their economies.  

Of course, as a country’s international debt approaches zero, the keepers of the index might drop it altogether.  But the fall in demand for that country’s remaining international bonds from the investment funds that are following the benchmark could then produce an undesirable discontinuous jump in the interest rate.

Many emerging market countries have paid down debt denominated in dollars or other foreign currencies, while continuing to borrow in their local currencies.  (See the table at bottom.)  Such relatively large countries as Thailand, Malaysia, Indonesia, South Africa and Russia, for example, have little dollar-denominated debt left - 3% of GDP or less (shown in the chart as the dark bottom of each first bar).   If an international bond benchmark is to be limited to dollar-denominated debt, then GDP weights could imply a severe imbalance between international investor demand for these countries’ bonds and the small supplies available. 

Accordingly, local currency denominated debt must be included in the most useful benchmarks.  But then a portfolio reallocation away from traditional benchmark indices such as the EMBI would imply a big shift in allocations away from simple credit risk toward currency risk.   True, the ability of emerging market economies to attract foreign investment in their local currencies represents an important strengthening of the global financial system, relative to the currency mismatch and balance sheet vulnerabilities of the 1990s.  Nevertheless, an investor switching from one “benchmark” to the other needs to be aware of the extent to which the reduction in default risk comes at the expense of heighted exposure to currency risk.

In short, it is not crazy for an investor to depart from the market-cap-weighted benchmark in the direction of putting more weight on debt/GDP countries and less weight on high debt/GDP countries.   But the GDP-weighted index should not be mistaken for a neutral benchmark.

[A version of this post originally appeared at Project Syndicate, Feb. 11, 2013.  Comments can be posted there, or at Seeking Alpha.]

Table:  Sovereign debts as a percentage of GDP

         A survey of economists is published in the November 2012 issue of Foreign Policy.  One question was whether we thought that the US unemployment rate would dip below 8.0% before the election.   When the FP conducted the poll at the end of the summer, unemployment was 8.1-8.2%.  Now it’s 7.8%.  Only 8% of the respondents said “yes.”   (I was one.  I basically just extrapolated the trend of the last two years.)   

My fellow economists choose defense spending and agricultural subsidies as the two categories of US federal budget that they think the best to cut.  They rate the euro crisis as the greatest threat to the world economy now and are particularly worried about Spain.   

For a slideshow presentation of the results, see “The FP Survey: The Economy.”   Or in a magazine format:  “If we’re ever going to get out of this slump, what will it take?  We asked more than 60 leading economists to tell us.”   

        Also, here is a recent poll from The Economist, asking similar questions of NBER and NABE economists:   “Asking the Experts,” Oct. 6.

       Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet.   Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961.  Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007.   Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable. 

The phrase “black swans” has come to be used to mean a very unlikely event of this sort.  Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time.   This is nonsense.  If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong.  This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it.    A still better interpretation is that statistical distributions have “fat tails,” in technical terms.  But it would be nice to get beyond the Jurassic Park lesson (”don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events. 

       What does “black swan” really mean?   In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries. 

      Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.”  The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19^th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction.   But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697.  A 19^th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books.  It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event.  A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

 2. “Terrorists don’t blow up big office buildings.”   Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings.   These warnings were not taken seriously by those in power at the time.   Many Americans did not know the history of terrorist events taking place in other countries and in other decades.  

 3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall.   After all, “they never had before,” which meant that they had not fallen in living memory in the United States.   They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s.  Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

 4. “Volatilities are low.”   During the years 2004-06, financial markets perceived market risk as very low.  This was most nakedly visible in the implicit volatilities in options prices such as the VIX.  But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices.  One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”).  They should have gone back much farther - or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

 5. “Big banks don’t fail.”   ”Governments of advanced countries don’t default.”   ”European governments don’t default.”  Enough said.  Greece’s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans.   The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk.  Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

      My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.

     My preceding post bemoaned the tendency for many US politicians to exhibit a procyclicalist pattern:    supporting tax cuts and spending increases when the economy is booming, which should be the time to save money for a rainy day, and then re-discovering the evils of budget deficits only in times of recession, thus supporting fiscal contraction at precisely the wrong time.  Procyclicalists exacerbate the magnitude of the swings in the business cycle.        This is not just an American problem.  A similar unfortunate cycle — large fiscal deficits when the economy is already expanding anyway, followed by fiscal contraction in response to a recession — has also been visible in the United Kingdom and euroland in recent years.   Greece and Portugal are the two most infamous examples. But the larger European countries, as well, failed to take advantage of the expansionary period 2003-07 to strengthen their public finances, and instead ran budget deficits in excess of the limits (3% of GDP) that they were supposed to obey under the Stability and Growth Pact. Then, over the last few years, politicians in both the UK and the continent have made their recessions worse by imposing aggressive fiscal austerity at precisely the wrong time.      Historically, developing countries used to be the ones where dysfunctional political systems produced procyclical fiscal policies.  Almost all of them showed a positive correlation between government spending and the business cycle during the period 1960-1999.  But things have changed.   Remarkably, during the decade 2000-2010, about a third of emerging market governments - in countries such as China, Chile, Malaysia, Korea, Botswana, and Indonesia - managed to reverse the historical correlation.  They took advantage of the boom years 2003-2007 to strengthen their budget positions, saving up for a rainy day.  They were thus in a good position to ease up when the global recession hit them in 2008-09.        In fact a majority of the governments that have followed countercyclical spending policies since 2000 are in emerging market or developing countries.   They figured out how to achieve countercyclicality during the last decade, precisely the decade when so many politicians in “advanced countries” forgot how to.

A recent video interview from Project Syndicate recaps some of my recent op-eds.  It covers the following territory:

•           The Obama Recovery.    The U.S. economy was in free fall in late 2008, whether measured by GDP statistics, the monthly jobs numbers, or inter-bank spreads.     Was the end of the recession in mid-2009 attributable to policies adopted by President Obama?   A full evaluation of that question to economists’ standards would require delving into the complexity of mathematical models.  The public generally has a simpler standard:   was the impact big enough to be visible to the naked eye?   Amazingly, the answer is “yes.”   Whichever of those statistics one looks at, and whether it is coincidence or not:  the economic free-fall ended almost precisely the month that Obama took office, January 2009.
•           Emerging markets have generally had much better economic fundamentals over the last decade than advanced economies.    For example, one third of developing countries have succeeded in breaking the historical syndrome of procyclical (destabilizing) fiscal policy.   For the first time, they took advantage of the boom of 2003-08 to strengthen their budget balances, which allowed a fiscal easing when the global recession hit in 2008-09.
•           The 15-year cycle in EMs.  Market swings that start out based firmly on fundamentals can eventually go too far.   Some emerging markets like Turkey look vulnerable this year.  A crash would fit the biblical pattern: seven fat years, followed by seven lean years.  Here are the last three cycles of capital flows to developing countries:
  • 1975-81: 7 fat years (”recycling petrodollars”)
  • 1982: crash (the international debt crisis)
  • 1983-1989: 7 lean years (the “Lost Decade” in Latin America)
  • 1990-1996: 7 fat years (Emerging Market boom)
  • 1997: crash (the East Asia crisis)
  • 1997-2003: 7 lean years (currency crises spread globally)
  • 2003-2011: 7 fat years (the triumph of the BRICs)
  • 2012: ?

Emerging markets have performed amazingly well over the last seven years. They have outperformed the advanced industrialized countries in terms of economic growth, debt-to-GDP ratios, and countercyclical fiscal policy.  Many now receive better assessments by rating agencies and financial markets than some of the advanced economies.

As 2012 begins, however, emerging markets may be due for a correction, triggered by a new wave of “risk off” behavior among investors. Will China experience a hard landing? Will a decline in commodity prices hit Latin America? Will the sovereign-debt woes of the European periphery spread to neighbors such as Turkey in a new “Aegean crisis”?

Engorged by large capital inflows, some emerging market countries were in an overheated state a year ago. It is unlikely that the rapid economic growth and high trade deficits that Turkey has experienced in recent years can be sustained. Likewise, high GDP growth rates in Brazil and Argentina over the same period could soon reverse, particularly if global commodity prices fall - not a remote prospect if the Chinese economy falters or global real interest rates were to rise this year. China, for its part, could land hard as its real-estate bubble deflates and the country’s banks are forced to work off their bad loans.

The World Bank has now downgraded economic forecasts for developing countries in 2012 (Global Economic Prospects, Jan.18, 2012).    Brazil’s economic growth, for example, came to a halt in the third quarter of 2011 and is forecast at only 3.4 percent in 2012 …well below the rapid 2010 growth rate of 7.5 percent.  Reflecting a sharp slowdown in the second half of the year in India, South Asia is coming off of a torrid six years, including 9.1 percent growth in 2010.  Regional growth is projected to ease further to 5.8 percent in 2012.

But will economic slowdown turn to financial crash?   Three possible lines of argument support the worry that emerging markets’ performance are fated to suffer dramatically in 2012: empirical, literary, and causal. Each line of argument is admittedly tentative.

The empirical argument is just historically based numerology: emerging-market crises seem to come in 15-year cycles. The international debt crisis surfaced in Mexico in mid-1982, and then spread to the rest of Latin America and beyond. The East Asian crisis erupted 15 years later, in Thailand in mid-1997, and then spread to the rest of the region and beyond. We are now another 15 years down the road. So is 2012 the time for the third round of emerging markets crises?

The hypothesis of regular boom-bust cycles is supported by a long-standing scholarly literature, such as the writings of Carmen Reinhart. But I would appeal to an even older source: the Old Testament - in particular, the story of Joseph, who was called upon by the Pharaoh to interpret a dream about seven fat cows followed by seven skinny cows.

Joseph prophesied that there would come seven years of plenty, with abundant harvests from an overflowing Nile, followed by seven lean years, with famine resulting from drought. His forecast turned out to be accurate. Fortunately the Pharaoh had empowered his technocratic official (Joseph) to save grain in the seven years of plenty, building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. That is a valuable lesson for today’s government officials in industrialized and developing countries alike.

For emerging markets, the first phase of seven years of plentiful capital flows occurred in 1975-1981, with the recycling of petrodollars in the form of loans to developing countries.  The international debt crisis that began in Mexico in 1982 was the catalyst for the seven lean years, known in Latin America as the “lost decade.” The turnaround year, 1989, was marked by the first issue of Brady bonds, which helped write down the debt overhang and put a line under the crisis.

The second cycle of seven fat years was the period of record capital flows to emerging markets in 1990-1996.  Following the 1997 “sudden stop” in East Asia came seven years of capital drought. The third cycle of inflows, often identified as a “carry trade,” came in 2004-2011 and persisted even through the global financial crisis. If history repeats itself, it is now time for a third sudden stop of capital flows to emerging markets.

Are a couple of data points and a biblical parable enough to take the hypothesis of a 15-year cycle seriously?  We need some sort of causal theory that could explain such periodicity to international capital flows.

Here is a possibility: 15 years is how long it takes for individual loan officers and hedge-fund traders to be promoted out of their jobs. Today’s young crop of asset pickers knows that there was a crisis in Turkey in 2001, but they did not experience it first hand. They think that perhaps this time is different.  

If emerging markets crash in 2012, remember where you heard it first - in ancient Egypt.

[This article was published in Project Syndicate, which holds the copyright.]

The prices of minerals, hydrocarbons, and agricultural commodities have been on a veritable roller coaster. Although commodity prices are always more variable than those for manufactured goods and services, commodity markets over the last five years have seen extraordinary volatility.

Countries that specialize in the export of oil, copper, iron ore, wheat, coffee, or other commodities have boomed.  But they are highly vulnerable. Dollar commodity prices could plunge at any time, as a result of a new global recession, a hard landing in China, an increase in real interest rates in the United States, fluctuations in climate, or random sector-specific factors.

Countries that have outstanding debt in dollars or other foreign currencies are especially vulnerable. If their export revenues were to plunge relative to their debt-service obligations, the result could be crashes reminiscent of Latin America’s debt crisis in 1982 or the Asian and Russian currency crises of 1997-1998.

Many developing countries have made progress since the 1990’s in shifting from dollar-denominated debt toward foreign direct investment and other types of capital inflows, or in paying down their liabilities altogether. But some commodity exporters still seek ways to borrow that won’t expose them to excessive risk.

Commodity bonds may offer a neat way to circumvent these risks. Exporters of any particular commodity should issue debt that is denominated in terms of the price of that commodity, rather than in dollars or any other currency. Jamaica, for example, would issue alumina bonds; Nigeria would issue oil bonds; Sierra Leone would issue iron-ore bonds; and Mongolia would issue copper bonds. Investors would be able to buy Guatemala’s coffee bonds, Côte d’Ivoire’s cocoa bonds, Liberia’s rubber bonds, Mali’s cotton bonds; and Ghana’s gold bonds.

The advantage of such bonds is that in the event of a decline in the world price of the underlying commodity, the country’s debt-to-export ratio need not rise. The cost of debt service adjusts automatically, without the severe disruption that results from loss of confidence, crisis, debt restructuring, and so forth.

The idea is not new. (The oldest reference I know is Lessard & Williamson, 1985.)  So, why has it not been tried before? When one asks finance ministers in commodity-exporting debtor countries, they frequently reply that they fear insufficient demand for commodity bonds.

That is a surprising proposition, given that commodity bonds have an obvious latent market, rooted in real economic fundamentals. After all, steel companies have an inherent need to hedge against fluctuations in the price of iron ore, just as airlines and utilities have an inherent need to hedge against fluctuations in the price of oil.  Each of these commodities is an important input for major corporations. Surely there is at least as much natural demand for commodity bonds as there is for credit-default swaps and some of the bizarrely complicated derivatives that are currently traded!

It takes liquidity to make a market successful, and it can be difficult to get a new one started until it achieves a certain critical mass. The problem may be that there are not many investors who want to take a long position on oil and Nigerian credit risk simultaneously.

A multilateral agency such as the World Bank could play a critical role in launching a market in commodity bonds. The fit would be particularly good in those countries where the Bank is already lending money.

Here is how it would work. Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil; it would then turn around and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. It can serve an additional important pooling function in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.  The Bank could link the bond it issues to an oil price index, a weighted average of various product grades.

An alternative for some commodity exporters is to hedge their risk by selling on the futures market. But an important disadvantage of derivatives is their short maturity. A West African country with newly discovered oil reserves needs to finance exploration, drilling, and pipeline construction, which means that it needs to hedge at a time horizon of 10-20 years, not 90 days.

Another disadvantage of derivatives is that they require a high degree of sophistication –both technical and political. In the event of an increase in a commodity’s price, a finance minister who has done a perfect job ex ante of hedging export-price risk on the futures market will suddenly find himself accused ex post of having gambled away the national patrimony. This principal-agent problem is much diminished in the case of commodity bonds.

If the international financial wizards can get together and act on this idea now, commodity exporters might be able to avoid calamity the next time the world price of their product takes a plunge.  The World Bank should take up the cause.

     After the currency crises of 1994-2001, and especially the East Asia crises of 1997-98, a lot of research investigated what countries could do to protect themselves against a future repeat.  More importantly, policy makers in emerging markets took some serious measures.  Some countries abandoned exchange rate targets and began to float.   Many accumulated high levels of foreign exchange reserves.  Many moved away from dollar-denominated debt, toward other kinds of capital inflow that would be less vulnerable to currency mismatch, such as domestic currency debt or Foreign Direct Investment.   Some instituted Collective Action Clauses in their debt contracts to facilitate otherwise-messy restructuring of debt in the event of a severe negative shock.  A few raised reserve requirements or otherwise tightened prudential banking regulations (clearly not enough, in retrospect). And so on.

When the Global Financial Crisis hit ten years later, it was bad news for everyone, except that it was good news for econometricians:  we could observe which countries got hit badly by this common external shock in 2008-09 and which did not, and could try to draw inferences about which strategies helped countries withstand the shock better than others.  The NBER is holding a public symposium in Washington on September 22.   The topic of the 3^rd and final session is: What ex ante policies can help reduce vulnerability to future shocks?

     Three papers that were presented at the earlier NBER conference in Bretton Woods (the culmination of a project on the Global Financial Crisis  sponsored by the Sloan Foundation) fall naturally into this category:

• International Reserves and the Global Financial Crisis, Kathryn Dominguez (University of Michigan), Yuko Hashimoto (IMF), and Takatoshi Ito (University of Tokyo);
• Managing Capital Inflows: The Role of Controls and Prudential Policies,  Jonathan Ostry, Atish Ghosh, Marcos Chamon, and Mahvash Qureshi (all of the IMF);
• International Financial Crises and the IMF: What the Historical Record Shows, Bergljot Barkbu (IMF), Barry Eichengreen (UC, Berkeley), and Ashoka Mody (IMF). 

To simplify a bit, Dominguez and co-authors study whether holding high levels of reserves helped countries do better in the Global Financial Crisis;  Ostry and co-authors study whether capital controls and bank regulation helped; and Barkbu, Eichengreen and Mody consider possible new mechanisms to improve the risk structure of capital inflows and to smooth adjustment to shocks, such as sovereign CoCos (Contingent Convertible bonds) and indexing of debt.

     The question that Dominguez, Hashimoto, and Ito address in International Reserves and the Global Financial Crisis, had been actively debated in the years before 2008.   Some economists thought that China, especially, but other emerging market countries as well, were holding far more foreign exchange reserves than they needed to withstand shocks.  Larry Summers (2006) was one prominent example; I must admit that his argument sounded sensible to me at the time.  When the global financial crisis hit, it was possible to test the proposition.   Some of the early studies found that reserve holdings did not seem to help countries withstand the crisis better.  Blanchard, Faruqee and Klyuev (2009) was one.   A series of papers by Andy Rose and Mark Spiegel (2009a, b) also found no significant effect.   But others found an important effect.    One of the technical contributions of the paper by Dominguez and co-authors is to subtract estimates of interest income and valuation changes from officially report levels of reserves in order to get at the actively managed component.  Their single most important finding is that real GDP growth recovery after the global financial crisis was stronger for countries that had accumulated large reserve holdings before the crisis.

This is the same thing I had found in a study with George Saravelos (NBER WP no.16047, 2010) .   Out of dozens of potential early warning indicators, foreign exchange reserves are the indicator that had been most often identified as significant by eighty pre-2008 studies conducted on earlier data.  We found that reserves are also the indicator that was the strongest predictor of which countries got into trouble in 2008-09. A particularly useful indicator is the ratio of reserves to short-term debt (Guidotti, 2003).   We found that the second most consistently important early warning indicator was overvaluation of the currency by criteria like PPP.   Also important in the recent crisis were measures of national saving.

Why did the Dominguez paper and my paper find that reserves had a significant effect, and others did not?    My guess is that it has to do with different definitions.  In particular, we define the crisis period as late 2008 and early 2009, whereas the earlier papers I mentioned ended in 2008.

     In Managing Capital Inflows: The Role of Controls and Prudential Policies, Ostry, Ghosh, Chamon, and Qureshi do something very important.  Too many discussions lump financial regulations together (speaking indiscriminately of Tobin taxes, Chile-style or Brazil-style controls on short-term capital inflows, Venezuela’s  controls on outflows, etc., even though these are completely different things).  Chamon and co-authors develop three new country indices: one for financial-sector capital controls, one for prudential regulation of foreign exchange transactions in the domestic banking sector, and one for domestic prudential policies.  This helps avoid exacerbating what is often a sterile oversimplified debate.  For example, even if one is ideologically opposed to capital controls, or has been persuaded by research such as Kristin Forbes (2007) that the famous Chile controls caused undesirable distortions, it is hard to be opposed to prudential banking regulations, especially in light of the origins of the 2008 crisis.   Chamon and co-authors find that capital controls and FX-related prudential measures can both help shift the composition of lending, away from FX-denominated bank loans and toward equity and FDI components of capital inflows.   Previous researchers have found that shifts of this sort in the composition of inflow, as opposed to reductions in the level of inflows per se, reduce the probability of a crisis. (Frankel and Rose, 1996, among many others.)   Probably the most important finding by Chamon et al is a reasonably strong statistical association between pre-crisis prudential and capital control policy and resilience to the sudden stop.   Countries in the upper quarter of restrictiveness of FX-related prudential measures do better in a crisis than those in the bottom quarter, by a whopping margin of 2 ½ - 3 ½ % percentage points of growth.  An important lesson for countries facing large inflows today.

     One of the co-authors of International Financial Crises and the IMF: What the Historical Record Shows, Barry Eichengreen, is not just the pre-eminent economic historian of this field but also supplied a lot of the intellectual force behind the adoption of Collective Action Clauses after the preceding round of emerging market crises (e.g., Eichengreen, 2003; and Eichengreen and Mody, 2004).  Thus it is well worth listening to what they have to say about further ideas for structuring capital flows ex ante in such a way as to avoid messy and costly restructuring ex post.

Barkbu, Mody, and Eichengreen explore how to automate the restructuring decision.  Automating the process has key advantages: it preserves the integrity of the contract (which avoids the uncertainties involved in triggering CDS); it is predictable; and it can be priced.   It can also avoid the need for what otherwise might be a lengthy process of renegotiation between debtors and creditors during which time economic activity falls and everyone suffers.  To this end, they discuss the idea of adding to future government bond issues so-called sovereign cocos, contractual provisions that automatically lengthen maturities or reduce interest and amortization payments when a pre-specified debt/GDP ratio is reached.  

There are also other ways of improving risk sharing and avoiding the need for costly restructuring negotiations.  An idea that is older but that I think merits more of a try-out than it has received — applicable for countries that export oil, minerals or agricultural commodities — is to index the debt to the world price of the export commodity.  Also in this category is the basic movement away from dollar-denominated debt and toward domestic-denominated debt, equity and FDI .  It seems to me that countries that heeded such lesson of the 1990s (including many emerging markets in Asia and Latin America) came through the GFC relatively well, whereas those that did not (Eastern Europe), did not.   

References

Barkbu, Bergljot, Barry Eichengreen, and Ashoka Mody, International Financial Crises and the IMF: What the Historical Record Shows, NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Berkmen, Pelin, Gaston Gelos, Robert Rennhack, and James P Walsh (2009), “The Global Financial Crisis: Explaining Cross-Country Differences in the Output Impact“, IMF Working Paper 09/280.
Blanchard, Olivier, Hamid Faruqee, and Vladimir Klyuev (2009), “Did Foreign Reserves Help Weather the Crisis“, IMF Survey Magazine, October.
Chamon, Marcos, Atish Ghosh, Jonathan Ostry, and Mahvash Qureshi, Managing Capital Inflows: The Role of Controls and Prudential Policies,   NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Dominguez, Kathryn, Yuko Hashimoto, and Takatoshi Ito, International Reserves and the Global Financial Crisis, , NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Eichengreen, Barry, 2003, “Restructuring Sovereign Debt,” The Journal of Economic Perspectives, Volume 17, Number 4, 1 November , 75-98.
Eichengreen, Barry and Ashoka Mody. 2004, “Do Collective Action Clauses Raise Borrowing Costs?,” Economic Journal, v114 (495,April), 247-264.   NBER WP 7458.
Forbes, Kristin, “One cost of the Chilean capital controls: Increased financial constraints for smaller traded firms,” Journal of International Economics,  71, Issue 2, April 2007, Pages 294-323
Frankel, Jeffrey and George Saravelos (2010), “Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis,” NBER WP 16047, June.
Frankel, Jeffrey, and Andrew Rose (1996) “Currency Crashes in Emerging Markets,” Journal of International Economics 41, no. 3/4, 351-66.
Guidotti, Pablo (2003), in J Antonio Gonzalez, V.Corbo, A.Krueger, and A.Tornell, (eds.), Latin American Macroeconomic Reforms: The Second Stage, University of Chicago Press.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2009), “Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008,” American Economic Review, 99(2):480-486.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2010), “Financial Stability, the Trilemma, and International Reserves“, American Economic Journal: Macroeconomics.
Rose, Andrew and Mark Spiegel (2009a), “The Causes and Consequences of the 2008 Crisis: Early Warning,” Global Journal of Economics. NBER Working Paper 15357.
Rose, Andrew, and Mark Spiegel (2009b), “The Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure,” Pacific Economic Review.
Summers, Lawrence, 2006,  “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation,” March 24.

[This column is co-authored with Carlos Végh and Guillermo Vuletin and was published in VoxEU.]

Everywhere one looks, problems of fiscal policy are now center stage.   Among advanced countries, the news is bad:   Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles.  But in the rest of the world there is better news:   In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.

In the past, developing countries tended to follow procyclical fiscal policy:   they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession.  Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.)   Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle.  Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.

Figure I (which is a version of evidence presented in Kaminsky, Reinhart and Vegh, 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999.   More precisely, it shows the correlation between the cyclical components of spending and GDP;  the longer term trends are taken out.   The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars.  A positive correlation indicates government spending that is procyclical, that is, destabilizing.  A negative correlation indicates countercyclical spending, that is, stabilizing.  

[Click here for enlargement of Figure I.] 

There is no missing the message.  Yellow bars lie overwhelmingly on the right hand side:  more than 90 percent of developing countries show positive correlations (procyclical spending).  Black bars dominate the left hand side:  around 80 per cent of industrial countries show negative correlations (countercyclical spending).

 Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world.     Figure II updates the statistics, showing the period 2000-2009.  The number of yellow bars on the left side of the graph (negative correlations) has greatly increased.   Around 35 percent of developing countries [26 out of 73] now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.  

[Click here for enlargement of Figure II.] 

Figure III presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis.  The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy.  The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.  

[Click here for enlargement of Figure III.] 

The evidence of countercyclicality among many emerging market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy:    debt/GDP ratios, rankings by rating agencies, and sovereign spreads.  Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40 percent of GDP over the last four years.  [The IMF estimates the 2011 ratio at 43 per cent among emerging market countries and 35 per cent among low-income countries]. This is the same period during which debt in advanced countries has risen from about 70 per cent of GDP to 102 percent.   The financial markets have ratified the historic turnaround.   Spreads are now lower for many emerging markets than for some “advanced countries.”    Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece.    Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.

Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries.   

What explains the ability of some countries, particularly emerging market and developing countries, to escape the trap of procyclical fiscal policy? Many researchers have pointed to the importance of institutions.  In new research we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality (which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment).    The relationship holds also when instrumental variables are used.

Although one thinks of institutions as slow-moving, they can change over time.   Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical.   A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions.   Chile did it with the structural budget reforms of 2000 and 2006.   Chile’s approach could be emulated by others.

Fiscal rules, such as euroland’s  Stability and Growth Pact, may accomplish little in themselves.   Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance.   Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.

Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South.  Saving during expansions such as 2001-06 is critical for weathering the storm in recessions such as 2008-09.  Otherwise there may be no way out but to adjust at the worst possible time.

    
      In 2008, the global financial system was grievously infected by so-called toxic assets originating in the United States.  As a result of the crisis, many have asked what fundamental rethinking will be necessary to save macroeconomic theory.  Some answers may lie with models that have in the past been applied to fit the realities of emerging markets — models that are at home with the financial market imperfections that have now unexpectedly turned up in industrialized countries.  The imperfections include default risk, asymmetric information, incentive incompatibility, procyclicality of capital flows, procyclicality of fiscal policy, imperfect property rights, and other flawed institutions.   To be sure, many of these theories had been first constructed in the context of industrialized economies, but they had not become mainstream there.   Only in the context of less advanced economies were the imperfections undeniable.  There the models thrived.     
 

     An analogy can capture the apparently novel suggestion that emerging markets may have important lessons for advanced countries.   In the latter part of the nineteenth century most of the vineyards of Europe were destroyed by the microscopic aphid Phylloxera vastatrix. Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock.   Purist French vintners initially disdained a strategy that they considered would compromise the refined tastes of their grape varieties. But it saved the European vineyards, and did not impair the quality of the wine. The New World had come to the rescue of the Old World.

     The academic literature on macroeconomics and finance in developing countries hardly existed 30 years ago.  But by now it has grown very large — large enough to deserve a survey of its own.  I review much of this research in a survey titled “Monetary Policy in Emerging Markets.”  It appears as a chapter in the Handbook of Monetary Economics, edited by Ben Friedman and Michael Woodford, which has just this week become available from Elsevier Publishing.   Among the hundreds of authors represented in the survey are Caballero, Calvo, Dooley, Dornbusch, Edwards, Reinhart and Velasco, as well as many younger scholars.  Again, although financial opening gave capital flows a central role in the emerging market models, the need to allow for imperfections in these markets has always been clear.   It is also what gives the models so much relevance today, not just for theory but for policy as well.   Raghu Rajan and Simon Johnson point out that some of the institutional failings that we associate with financial sectors in developing countries, such as distorted incentives and undue political influence, also apply to the United States and other advanced countries.  Among other areas of economic policy where the North could draw useful lessons from small countries in the South as to how to address the problems, in earlier blogposts I have given the example of the procedures that Chile has used over the past decade to achieve countercyclical fiscal policy.  

[Comments can be posted on the Belfer Center site.]